Teekay LNG Partners Pullback Offers Chance At Quality For A Discount

Teekay LNG Partners (NYSE:TGP) generated distributable cash flow (DCF) of $43.7 million in the third quarter–up 19 percent from year-ago levels–covering its quarterly distribution of $0.63 per unit by roughly 1.08 times.

The partnership owns a fleet of 20 ships that transport liquefied natural gas (LNG), five vessels that carry liquefied petroleum gas (LPG), and 11 conventional oil tankers. Nine additional LNG tankers will join the fleet over the next six to 12 months.

Teekay LNG Partners leases these vessels to customers for a daily fee, and virtually all the company’s ships–including those soon to be delivered–are booked under long-term charters that guarantee cash flows for the duration of the contract. The average charter covering the MLP’s LNG tankers is 16 years, while the firm’s LPG carriers have an average of 15 years remaining on their outstanding contracts. The company’s oil tankers average 10 years of contract coverage.

As these time charters feature fixed day-rates, Teekay LNG Partners grows its DCF primarily by expanding the size of its fleet. Much of the 19 percent uptick in the company’s third-quarter DCF stemmed from the acquisition of ownership interests in five LNG and LPG carriers: a 50 percent interest in two LNG carriers in November 2010; a 100 percent interest in an LPG carrier in June 2011; a 33 percent interest in an LNG carrier in August 2011; and a 100 percent interest in a new LPG carrier in September 2011.

Day-rates in the oil tanker business continue to hover around multiyear lows because an influx of new vessels has swamped demand. Many of these ships were ordered in 2005 and 2006, when day-rates were near a record high. In many instances, rates in the spot market and on new time charters have collapsed to levels where operators can’t even turn a profit.

But conditions in the market for LNG and LPG carriers remain sanguine: Neither faces an oversupply of vessels, and day-rates offer attractive returns on investment. During a recent conference call to discuss third-quarter results, Teekay LNG Partners’ management team noted that immediately available large LNG tankers currently command $120,000 per day, compared to about $100,000 per day in August.

Demand for these ships has grown dramatically after the devastating earthquake and tsunami that hit Japan’s Tohoku region and the subsequent disaster at the Fukushima Dai-ichi nuclear power plant. Prior to the crisis, Japan had generated about 30 percent of its power from nuclear energy. Previous plans to have nuclear power contribute 40 percent of the nation’s electricity by the decade have been shelved for the time being. All of the reactors at the Fukushima Dai-ichi site have been permanently closed, and Japan has idled much of its nuclear capacity for safety inspections. Some of these nuclear power plants are unlikely to reopen.

To replace this lost capacity, Japan will turn toward natural gas-fired plants that emit less carbon dioxide than coal-fired plants and can be built relatively quickly. Japan lacks domestic stocks of natural gas and continues to step up its LNG imports to offset lost nuclear power. The nation in October imported 6.12 million metric tons of liquefied gas, up 17.9 percent from year-ago levels.

Germany has also shuttered its older reactors and plans to close all of its reactors by 2022. Nuclear power accounts for about 25 percent to 30 percent of Germany’s electric supply; natural gas-fired plants will replace much of this lost generative capacity. LNG will fill some of the supply gap, as Germany attempts to limit its dependence on pipeline gas from Russia.

These developments have elevated day-rates on LNG tankers significantly and led to a pick-up in fixing activity, which suggests that shippers are seeking longer-term deals to ensure they have sufficient capacity to transport cargoes of liquefied gas.

Tanker companies have responded to higher rates and strengthening demand by ordering new LNG carriers. Thus far in 2011, companies have ordered more than 30 LNG tankers that have yet to be booked under time charters. But this influx of new vessels shouldn’t tip the market for LNG tankers into an oversupply.

Teekay LNG Partners’ management noted that LNG shippers are willing to sign one- to three-year contracts at today’s sky-high rates of $120,000 per day. Market participants also expect the supply-demand balance to remain tight for some time; customers are booking deals longer-term deals with fixed day-rates of $80,000 to $90,000.

But the highlight of Teekay LNG Partners’ third-quarter results was the recently announced deal to purchase interests in eight LNG tankers from A.P. Moller-Maersk for USD1.4 billion.

(Click to enlarge)

Source: Teekay LNG Partners LP

The MLP is buying these ownership stakes through its 52 percent-owned joint venture with Japan’s Marubeni Corp (Tokyo: 8002). The deal is expected to close in early 2012.

The eight vessels involved in this transaction are relatively new, and five of these ships are booked under long-term charters that are of similar duration to the agreements covering Teekay LNG Partners’ other vessels.

Management indicated that the shipper leasing the Maersk Meridian under a short-term charter is likely to exercise an option to extend the contract by another 18 years. The two other short-term contracts expire in March 2012 and March 2013, respectively. Management has indicated that customers have already expressed interest in booking these vessels at a higher day-rate. However, it remains to be seen whether Teekay LNG Partners will pursue short-term charter deals that feature higher day-rates or seek longer-term agreements that pay a slightly lower day-rate.

In the past, Teekay LNG Partners has erred on the side of conservatism, which leads me to believe that the firm will book at least one of these newly acquired LNG tankers under a longer-term charter. That being said, if the joint venture opts for shorter-term contract on one vessel, the MLP’s overall risk profile wouldn’t change; the remainder of its LNG carriers are booked under longer-term deals.

Of course, the best news for investors is that Teekay LNG Partners plans to boost its quarterly payout to $0.675 per unit in May 2012 from the current rate of $0.63 per unit. Although an increase to the distribution is always a welcome development, this news also signals management’s confidence that the deals will prove accretive to DCF.

Nevertheless, units of Teekay LNG Partners have pulled back in recent weeks. Some of this weakness stems from a recently announced secondary offering of 5.5 million new units plus an over-allotment option. As the new units technically dilute the value of existing unitholders’ positions, the knee-jerk reaction for some shortsighted investors is to sell the stock.

But this deal isn’t truly dilutive to existing unitholders because Teekay LNG Partners will use the proceeds to pay for its share of the ownership stake in the eight A.P. Moller-Maersk LNG tankers. In turn, this deal will generate additional cash flow that the MLP can use to boost its distribution.

Savvy investors can boost their returns by buying the inevitable dip that occurs after an MLP announced that it will issue new units. Historically, units of solid MLP investments have recovered quickly from these selloffs, as investors soon realize that the proceeds will fund deals that will enable the partnership to boost its quarterly payout.

The stock has also suffered from guilt by association. That is, conditions have deteriorated dramatically in the market for oil tankers, scaring investors away from any names associated with this business. Although Teekay LNG Partners isn’t an oil tanker company and has all of its vessels locked into long-term contracts, ill-informed pundits often lump the firm into the tanker category.

The market’s misunderstanding affords investors an opportunity to buy units of this high-quality, rapidly growing MLP at a discounted valuation. At current prices, the units yield about 7.6 percent.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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